IRAs, or individual retirement accounts, are a popular retirement savings tool known for offering tax-deferred or tax-free growth for efficient retirement savings. But how do traditional IRAs compare to Roth IRAs? And which one should you invest in?

Understanding how each of these accounts function can help guide you to an informed decision. While both options are great tax shelters for your retirement planning, we will explore the key differences between Traditional and Roth and the limitations to each.

What is a Traditional IRA?

A traditional IRA is an individual retirement account that offers tax-deferred growth. This type of IRA is funded with pre-tax money, which means that you can deduct a percentage of income and contribute to the account up to certain limits. In addition to taking a tax break up front, the funds inside the account also grow tax-deferred, meaning that you are not taxed on any gains until you make a withdrawal.

With traditional IRAs you have a greater ability to forecast your tax liability and systematically plan withdrawals. The primary use case for traditional IRAs to save for retirement, however they also allow for penalty free withdrawals for certain situations such as, emergencies, mortgage down payments, college, medical, or adoption expenses to name a few. The funds in the account can be invested in a variety of assets, such as stocks, bonds, and mutual funds, which means your IRA is generally fairly liquid compared to other investment options.

Secure 2.0 Changes for Traditional IRAs

The Secure 2.0 Act, which was signed into law in December 2022, made several changes to traditional IRAs. These changes include:

Increased contribution limits: The Secure 2.0 Act included an indexed catch-up contribution for individuals over 50 years old. While currently $1,000, that catchup amount is scheduled to index for inflation beginning in 2024. A separate catch-up amount for retirement plans, currently $6,500 for 401(k)s and $3,500 for SIMPLE IRAs would be increased to $10,000 and $5,000 respectfully for ages 60-63.

Required minimum distributions: The original Secure Act changed the age for required minimum distributions (RMDs) from 70 ½ to 72. The Secure 2.0 act took this another step by increasing this age to 73 (for those that turn 72 after 12/31/2022). For those that were born after 1960, the RMD age is now 75. This was an important change to help preserve pretax retirement options from early depletion, since RMDs increase annually until all funds have been withdrawn.

These changes make traditional IRAs even more attractive for individuals looking to save for retirement.

Exploring Roth IRAs

Roth’s are another type of IRA that offer tax-free growth and distribution flexibility. While you don’t get a tax deduction for the initial contributions made to a Roth, there are great benefits for the tradeoff.

The biggest benefit is the lack of taxation on any capital gains the account generates. Not only can the accounts grow tax free, but since you’ve already paid taxes on the money you contributed, you aren’t taxed when taking a withdrawal of your contribution capital either. The ability to contribute to a Roth IRAs is subject to income limits, so it is important to check whether you are eligible to contribute before investing.

Unlike Traditional IRA’s, Roth accounts do not have mandatory RMD requirements. This allows for much more flexibility when choosing how and when to distribute assets. It also makes a great asset to hold for estate planning, as beneficiaries will not incur a tax bill when it is distributed.

Tax Planning with IRA Accounts

Individual Retirement Accounts are a great tool for maximizing your tax planning. There are several ways to use IRAs to your advantage, depending on your financial situation and goals.

Tax bracket arbitrage is one strategy that involves taking advantage of the differences in tax rates between your current tax bracket and the one you expect to be in during retirement. One way to implement this strategy using IRAs is to contribute to a traditional IRA while you are in a higher tax bracket and then withdraw the funds during retirement when you are in a lower tax bracket. This can result in significant tax savings over the long term. For example, if you are currently in the 32% tax bracket and expect to be in the 22% bracket during retirement, contributing the maximum amount each year to a traditional IRA can help you defer taxes at a higher rate and withdraw them at a lower rate.

In contrast, if you expect to be in a higher tax bracket during retirement years, contributing the maximum to your Roth IRA each year can allow you to build a pool of tax-free funds for the future. Paying the taxes on contributions while you’re in a lower tax bracket can help save thousands of tax dollars over your lifetime.

Another strategy for maximizing tax planning using IRAs is to consider a Roth conversion strategy. This involves transferring funds from a traditional IRA to a Roth IRA, which results in tax-free growth and withdrawals in retirement. This strategy can be particularly beneficial if you expect to be in a higher tax bracket in retirement or if you want to minimize your required minimum distributions (RMDs) during retirement. However, it's important to note that Roth conversions are considered ordinary income and subject to taxes in the year of the conversion, so it's important to carefully consider the tax implications and potential benefits before making the switch. While contributing to a Roth account directly does have income limitations, you don’t have to worry about income limitations on Roth conversions.

Income Smoothing

Income smoothing is a financial strategy that aims to even out income fluctuations over time. This can be especially helpful for those with unpredictable annual income, such as freelancers or entrepreneurs.

One way to achieve income smoothing using IRAs is to withdraw funds from your traditional IRA during years when you have lower income; helping to offset the income loss and potentially reduce your lifetime tax bill. However, withdrawals from traditional IRAs are subject to taxes and additional penalties if done before age 59 ½, so planning ahead and carefully considering the timing and amounts of withdrawals can help reduce extra fees.

In addition to Traditional accounts, you can also use your Roth IRA to help smooth out income in retirement by withdrawing funds when you need them, without triggering additional taxes. Consulting with a financial advisor or tax professional can help you develop a plan for income smoothing using IRAs that takes into account your individual financial situation, goals and spending needs.

Whether you're just starting out or are approaching retirement, incorporating traditional and Roth IRAs into your overall retirement plan can help you achieve your financial goals and enjoy a comfortable retirement. Traditional and Roth IRAs are valuable tools that can help you achieve a more predictable income as well as save on taxes. Both types of IRAs have their own unique benefits and drawbacks, and choosing the right strategy for your individual financial situation and goals can be complex. However, with careful planning and the help of a financial advisor or tax professional, you can use IRAs to build a strong foundation for your retirement savings and ensure that you're making the most of the tax advantages they offer.

Please consult with an attorney or a tax or financial advisor regarding your specific legal, tax, estate planning, or financial situation. The information in this article is not intended as legal or tax advice.